Welcome to the RFF Weekly Policy Commentary, which is meant to provide an easy way to learn about important policy issues related to environmental, natural resource, energy, urban, and public health problems.

In principle, there are two potential rationales for subsidizing renewable fuel technologies. First, a subsidy might be warranted to the extent this helps to displace fossil fuel technologies and emissions from those fuels are underpriced. Second, a transitory subsidy might be warranted if, by producing a new (immature) technology, firms lower their production costs over time through “learning-by-doing”, which confers benefits to later producers of the technology. This week, Kenneth Gillingham, Arthur van Benthem, and James Sweeney discuss whether these arguments might justify California’s program of temporary subsidies for solar photovoltaic installations.

California has been at the forefront of environmental policy in the United States for the past several decades, with policies like energy efficiency standards and air quality standards often preceding similar legislation at the national level. Recently, California has undertaken one of the largest renewable energy incentive programs in the world: the California Solar Initiative (CSI). The CSI provides for a significant rebate (in dollars per watt) on solar photovoltaic (PV) installations that begins at roughly $3.50 per watt and phases out progressively over the 10 year span of the policy. This ambitious program has spurred the California solar market, but, to this day, solar PV technology remains quite expensive when compared to grid electricity, leading to the question: does this significant investment make sense?

Solar Policy in California

Let’s first examine how solar policy has evolved in California. The state’s interest in solar energy is not at all surprising—California enjoys copious sunshine and has strong environmental values, as well as an enviable base in high technology. In fact, solar policy in California is nothing new; a sizeable rebate per installation was in place before 1998, and a tax credit has been in place since 2001. These have served to foster a rapidly growing solar PV industry—from under 5 megawatts (MW) installed in 2000 to nearly 198 MW installed by the end of 2006.

Nevertheless, the solar PV market in California has faced two major hurdles: cost and uncertainty. Electricity from solar PV systems is much more costly than grid-based electricity, due to the high upfront cost of PV installation. Solar PV electricity often costs roughly 20 cents per kWh, which is much greater than the price of grid electricity—in the order of 12 to 15 cents per kWh in California. Prior to the initiative, solar subsidies were subject to renewal each year, leaving investors and solar installers with variable prospects. For these reasons, solar energy makes up only a tiny fraction of the total electricity supply in California—even today it is less than 0.5 percent.

In January 2004, Governor Schwarzenegger set in motion the plan that would eventually become the CSI, through his evocatively named “Million Solar Roofs Initiative.” The California Public Utilities Commission’s January 12, 2006 rulemaking implemented key elements of this original vision and created the CSI, providing the assurance of incentives over 10 years, at a revenue cost of approximately $3 billion per year.

The incentives are implemented as a rebate in dollars per installed watt, paid for by an electricity ratepayer surcharge. They can be applied to residential, commercial, industrial, or even government installations, but not to central generation solar (solar thermal plants, for example). Importantly, the incentives are designed to be progressively phased out over the 10-year policy lifespan, corresponding to an expected decline in the cost of solar PV technology due to learning-by-doing, as explained below—a key element of the justification in Sacramento for the solar incentives.

Rationale for Solar Incentive Policies

If solar PV technology is so much more expensive, why should California bother to subsidize it? A few primary arguments stand. The first is the most well-known: more electricity from solar will mean less electricity from fossil fuels, thereby avoiding the well-known environmental externalities. The second is that peak solar radiation is highly correlated with times of high electricity spot prices, such as in the middle of a summer day, and consumers do not take this correlation into account because they only face the mean price of electricity, namely the price for kilowatts per hour.

A third argument is more controversial, but turns out to be critical. There is evidence suggesting a learning-by-doing (LBD) effect, whereby the cost of solar installations declines as cumulative solar installations increase. On the surface, LBD may not seem to provide motivation for public policy. But if the installation of an additional solar PV system today leads to less expensive solar PV systems for all firms in the future—that is, there is a spillover effect that the individual firm cannot capture—then the profit-maximizing firm will install fewer systems today than what would result in socially optimal environmental and consumer benefits.

Is the CSI Justified?

We aimed to answer this question by developing a model of the California solar market. Our results suggest that LBD spillover effects that cannot be fully captured by the individual firm are critical to justifying the CSI. We find that without these effects from LBD, the CSI cannot be justified by the combination of its environmental and temporal correlation benefits alone. However, by inclusion of these LBD effects, we find an important result: the CSI can be justified on the grounds of improving economic efficiency. The consumer benefits from reduced PV installation costs in the future, resulting from additional installations today, greatly outweigh the environmental benefits—tipping the balance in favor of the CSI. Moreover, we find that the socially optimal policy may be quite similar to the CSI.

Kenneth Gillingham is a Ph.D. candidate at Stanford University and a former RFF research assistant. His research has focused on the economics and modeling of technological innovation in new energy technologies. He is the recipient of a Fulbright to New Zealand, and has been a fellow at the Council of Economic Advisers and a research assistant at the Joint Global Change Research Institute of Pacific Northwest National Laboratory.

Arthur van Benthem is a Ph.D. student in economics at Stanford University. His interests and research are in energy and environmental economics. Before coming to Stanford, he worked as an energy economist in the Shell long-term energy scenarios team.

James L. Sweeney, of Stanford University, is director of the Precourt Institute for Energy Efficiency, professor of management science and engineering, and is a senior fellow at the Stanford Institute for Economic Policy Research, the Hoover Institution, and the Woods Institute for the Environment. His professional activities focus on economic policy and analysis, particularly in energy, natural resources, and the environment.

Here’s why. The cost of a solar PV installation can be broken into three major components: the module made up of the PV cells, the electric inverter to convert the electricity generated by the cells, and the remainder, which covers the balance of the system—namely marketing, management, supply chains, and the physical installation, which combined make up roughly just under half of the total cost of an installation. It is this last component of the total cost that is the most relevant here, for there is some evidence to suggest localized LBD. The idea is pretty straightforward: as installers gain more experience, some of this knowledge will spill over to other California installers. This benefit, not captured by the individual installing the system now, is large enough to justify the CSI subsidy on economic efficiency grounds. However, our key result is that without this LBD effect, the cost of the CSI cannot be justified on economic grounds.

The model quantifies these separate impacts. The present value of the decreased costs of future installations due to LBD caused by one additional installed kilowatt of solar is estimated to be $1,140; the present value environmental benefit from reduced carbon dioxide (CO2), if we assume a CO2 damage of $50/ton of CO2, is only $192. This numerical estimate indicates that the primary motivation for solar policy in California should be LBD. If we do not believe that there are LBD spillovers, the environmental reasons alone are not sufficient to justify the ambitious CSI.

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Views expressed are those of the author. RFF does not take institutional positions on legislative or policy questions.

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